Wouldn’t it be great if we had a crystal ball that told us the movement direction of a stock or an option in the near future? My partner Mike always says, let me know the movement of a stock for only the next five minutes and I’ll become wealthier than Warren Buffet!. How about this? Suppose there was a newspaper that came out in the evening and gave you that movement on certain stocks and or options the next morning!
OK. I hear all you naysayers yelling that there is no such thing, so get off the subject.
Well, not so fast my skeptic minded friends. I don’t blame you for being skeptical when it comes to stock and option trading. But while it is true that there is no such thing as a crystal ball or a newspaper that gives futures results, there are valuable indicators that stock and option traders have at their fingertips that can substantially increase one’s odds of making a winning trade. I am not talking about using charts to find support and resistance points, or moving day average cross-overs, or MACD Indicators, or anything like that. I am talking about something that is easier to read than all those indicators.
So, you ask, then what is it?
I will tell you, but before I do, let me say this: This indicator is so simple you might have the tendency to throw it aside and say –Big Deal! But read this entire article with an open mind then test it out on a number of paper trades before you dismiss the idea. I think you will find it more like a crystal ball than you may now believe is possible.
OK here is.
It is the Put to Call ratio. This is a ratio between all of the option volume for the Puts versus the Calls of a particular stock for the current month’s expiration. You can also check out the following month’s expiration to see if the Put/Call ratio is similar. This next part is very important! The Put/Call ratio is of particular interest on stocks that are announcing their earnings after the market closes on a particular day or in the morning prior to the open. Disregard any stocks on earnings announcement that happen during trading hours.
Here is what to look for. First, you want to find stocks that are announcing their earnings for a particular day as mentioned above. You can find this information on Yahoo Finance Earnings Calendar page which gives earnings dates and times out into the future so you can prepare well in advance. Or you can go to the Briefing.com Calendar page and it will give you the same type of information. With Briefing.com, you must register first to go to the calendar, but it is free.
Second, in the earnings calendar, look for stocks with a daily volume of 500K or more.
Third, during the market hours on the afternoon of a stock announcement, check out the option chain for the current month’s expiration on a stock that interests you. Extend the chain to see all options trading for that month. You want to see individual option strikes that are trading in the hundreds or even better, in the thousands. If the day’s volume in most of the options are light, research another stock. But assuming you found a big volume of options being traded, tally up the volume traded (not the open interest) for the Calls and all the volume for the Puts. If there is a very heavily weighted volume on one side or the other, there in lies your crystal ball! For example, if the day’s volume of trades on all the options for the current month totals out to say 15,000 and all the Puts only total 3,000, it means many traders have some reason to believe the stock is going up the next morning after the company announces its results. And visa versa. The bigger the ratio the more reason to believe that there are traders that have gleaned enough information to give them a strong belief in what the outcome will be. So why not take advantage of the collective brain power?? The smallest ratio we look at is 3 to 1.
And here is another nifty piece of information. Check out the strikes that have the biggest volume. That could indicate that traders believe the stock will move up or down to that strike price after the announcement. For example, let’s say the stock is currently trading at $37.00 before the announcement and the Put/Call ratio is pointing to an up move. You check out the option chain and you see a much bigger volume in the 40 strike Call than the other strikes. This could indicate that many traders believe the stock is going to trade up to or above $40.
Fourth, if you want to add more to your knowledge you can also go back four or five quarters and study what a particular stock did during the company’s last announcements. You can find previous earnings dates on Briefing.com using the calendar page. Find the dates, then check out the movement on a chart for those dates. What you want to look for is direction of movement. If the stock tends to continue further in the same direction of its gap on the trading day after the earnings announcement, that is good. In other words, if it gaps $2.00 in the Pre-market, then tends to move up another $1.00 or $2.00 more during the regular trading day, that is what we are looking for. If it tends to reverse on several occasions, nix the play.
OK, so now that you know what to look for, what kind of a trade do you make on it? It is actually pretty simple. If after you made your studies you believe the stock is going up for example, buy a Call before the close of the market the day of the announcement (after market close) or the day before if the company is announcing the next morning. Conversely, buy a Put if you see it as a down play. The closer to the money or deeper in the money you buy the option, the bigger the potential profit. But also, the bigger the potential the loss is if, for whatever reason, the strategy bombs. And there are things that can ruin a play such as some late breaking news about the stock or an overall market that is substantially moving in the opposite direction from your trade.
So you may want to pick a cheap out-of- the-money option so your risk is minimized. If you buy a $3.00 at the money option for example, you are going to be more nervous about the outcome. But if you buy an out of the money option for say $.75 or $.50 you most likely will be more relaxed realizing the most you can lose is $.75. If that is your risk tolerance then you can take more risk in the morning after the announcement. If it gaps in your direction well and you have a nice profit in it, you may be willing to let it ride a bit to see if you can increase that profit. Or if it goes in the wrong direction, you might be more willing to let it ride to see if it comes back in your favor when you have a less expensive option. Play with an options calculator to see what the theoretical outcomes could be before deciding on what option to trade.
Finally, the next day after the market opens, if your option is well in the profit, don’t get greedy. If your $.75 option is now worth $1.50 realize that it is a 100% profit! For Pete’s sake, if that is the case, take your profit immediately. But if you think you want to hold for a bigger profit (this is being very greedy), you have no idea what might happen, so holding for more becomes like gambling.
Please note, this is in no way a recommendation from SplitMaster.com. The information presented here is only for educational purposes. While this play can be profitable, you should not attempt to make such a trade unless you have a full understanding of the type of option play you are making and understand well the possible outcomes and risks involved. If you are newer to option trading, consult your broker or financial adviser before making such a trade. And always paper trade a new strategy several times before making an actual trade
Did you enjoy the article and understand the benefits? You did?? Great! Well, Tony Ponzo has a lot more of these types of ideas. Check out the strategies on his site SplitMaster.com and his newly published ebook, Never Let Wall Street Steal Your Money Again! The book is packed full of step by step instructions on the fundamentals of stock and option trading and has tons of option strategy ideas for every market condition. Get a Free Preview Also, send us your questions and comments to contact@splitMaster.com